Personal Finance: Housing crisis likely to taint credit scores

For countless Americans struggling to make their mortgage payments, the problems have just begun.

Although a loan modification or foreclosure might let them put their housing problems behind them, millions will be dogged for years by a credit score so tarnished by the housing debacle that lenders will want to avoid them. If they are able to obtain loans, high interest rates are likely to strain their budgets.

The effects may well be a drag on the nation's consumption, and the economy as a whole, for a decade or more.

Changes are in the works in the way credit scores are calculated and applied that could dramatically affect all Americans' ability to borrow. Many bankers say the overreliance on a simple credit score did not work well for lenders or consumers.

"Industrywide, we've had a colossal failure" in properly managing lending, Kenneth Phelan, the chief risk officer of mortgage finance giant Fannie Mae, told bankers focused on cutting their risk exposure at the Risk Management Association's annual conference this month.

Even as Americans work off their debt, their future spending will be dogged by their past.

In the case of foreclosures, for example, a person who had a solid credit score before her housing nightmare could see it fall more than 15 percent under the system used by VantageScore, a scoring mechanism involving the nation's three main credit bureaus, Experian, TransUnion, and Equifax.

Even if the person had paid all bills on time before, future lenders would see her as a subprime borrower, which would make obtaining loans difficult.

"That's why we encourage people to seek modifications, not foreclosures," said Barry Zigas, director of housing policy for the Consumer Federation of America, because modifications hurt credit scores less.

If people go into bankruptcy, every lender they approach for the next seven to nine years will know it. The lenders may decide to turn them away, although people who pay every bill on time can rebuild their score and regain lenders' confidence.

Meanwhile, bankers are expected to be increasingly gun-shy about making any loans. They are looking at changing the way they make decisions - building in factors that are "more judgmental," Zigas said.

That could be good or bad for borrowers. If, for example, a borrower lost a home because he lost a job and couldn't sell his house because it was in a depressed area, a future lender might take that into consideration.

But some bankers are beginning to consider factors such as geography and the overall economy. So people who are transferred to a depressed area could have trouble buying a home there, even if they have good credit.

Firms such as Moody's Analytics are trying to sell a new credit scoring system that considers other factors that could endanger a bank's ability to collect on a loan.

For example, Tony Hughes, senior director of the credit analytics group at Moody's Economy.com, of West Chester, outlined to bank risk managers at the conference a new system that reduces credit scores during economic booms.

The idea is that during such periods, people appear to have pure credit scores because of the environment. They were able to borrow against home equity and pay off credit cards, but later that equity vanished as home prices fell. During boom times, more people also borrow to speculate, another risk to lenders, Hughes said.

At the bottom of a recession with a recovery in sight, Hughes said, credit scores would be raised to reflect the idea that a person buying a home would be paying it off in an improving economy, with home values increasing and with less risk that they would lose their job. A person who lived in a distressed area and paid a loan during a recession could receive extra points.